Interview With Michael Melby, Founder Of Gate City Capital Management

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Includes: PICO, UCP
by: Nicholas Bodnar

Summary

Michael Melby runs a deep-value, concentrated, micro-cap fund.

He looks for companies with a high margin of safety, clean balance sheet, understandable business model and meaningful upside potential.

Part of Melby's due diligence process is visiting companies. Over the past two years he has visited companies in over 35 U.S. States.

The fund was launched in 2014 and is currently located in Chicago.

Who is Michael Melby?

Nick, thanks for having me and for your interest in Gate City Capital Management. I was born and raised in Glendive, Montana, a small town in Eastern Montana. Glendive was nicknamed the "Gate City" and the name and logo of the firm pay tribute to my hometown. As an undergrad, I attended the University of Notre Dame where I majored in finance. After my studies, I worked in fixed income at Deutsche Bank on Wall Street and then returned to Notre Dame to work for the Notre Dame Investment Office. I earned my MBA from the University of Chicago in 2011 and worked as a research analyst at Crystal Rock Capital after business school. I left Crystal Rock Capital in June of 2014 to launch Gate City Capital Management to outside investors.

How did you get into investing and what made you want to start a fund?

My father was a high school business teacher, and he got me interested in business and investing at a young age. I began investing in high school with savings I had accumulated from part-time jobs. Around that time I also decided that I would like to focus on investing as a career. I majored in finance at Notre Dame and was especially influenced by the Applied Investment Management or "AIM" course. AIM was a high-intensity class where students served as research analysts as well as co-portfolio managers for several million dollars of the Notre Dame Endowment. After taking the class, I knew that I wanted to manage an equity fund. I found the process of utilizing fundamental research in order to uncover information and value companies to be very exciting. Applying this knowledge and ultimately investing capital in a company is the final step and is what capitalism is all about.

What is your investing style?

Gate City Capital Managements manages a concentrated portfolio of deep-value U.S. microcap companies. I look for companies that are trading at a sharp discount to their intrinsic value and that provide investors with a meaningful margin of safety through the ownership of real assets such as land, buildings, and equipment. In addition, I look for companies with clean balance sheets, understandable business models, and sustainable competitive advantages. I complete a full due diligence process on every company before making any investment. This includes visiting with management teams and touring company facilities. I focus intently on the price paid and only look to purchase stock at a price that represents an attractive price to purchase the entire business. I have a long-term time horizon for every investment and expect to hold each company for a minimum of two years. Finally, the Fund has a concentrated portfolio and targets between 12 and 15 total positions. This creates a portfolio of best ideas, necessitates a full due diligence process, and makes each position meaningful to the overall portfolio.

Do you think traveling to meet with companies is a good use of your time?

I find travelling to meet with companies to be an essential part of the due diligence process and a very good use of my time. Over the last two years, I have visited companies in 35 U.S. states. I find that there is no better way to understand the quality of the management team than by a face-to-face meeting. In addition, company visits provide the opportunity to "kick-the-tires" by observing the condition of the facilities, the engagement of company employees, and the quality of the product being produced. Although company visits are helpful in confirming the upside potential of a company, I find visits to be especially helpful in providing conviction in the margin of safety of each company. In the event the company's stock does decline in price, I generally have conviction in both the quality of the management team and the company's assets to either maintain or even add to position sizes. Developing a positive relationship with management also helps establish our reputation as a long-term business owner rather than as a trader or speculator. In addition to visiting management teams prior to making an investment, I also look to attend annual shareholder meetings. This further reinforces the firm's status as a long-term business owner and also helps extend our relationship with the company to all levels of senior management as well as the board of directors. This process has helped Gate City Capital Management build sustainable long-term relationships with a number of management teams in a relatively short period of time, and I expect these relationships to prove to be very valuable in the years to come.

Biggest influencers in and out of the investment landscape?

The biggest influencers for me are my parents. In addition to providing me with an interest in investing, they also instilled in me a set of values focused on doing the right thing and treating people with respect. My biggest influencer in the investment world is Scott Malpass, the Chief Investment Officer of the Notre Dame Investment Office. In addition to being a personal friend and a top-notch investor, Scott taught me several keys to investing that have stood with me to this day: namely take a long-term approach, have a passion and care for the people you are investing for, and always focus on areas where you can achieve a long-term competitive advantage.

A company you find attractive and why?

A company I find attractive is PICO Holdings Inc. (NASDAQ:PICO). PICO owns water rights and other water assets in the American southwest through a wholly-owned subsidiary called Vidler Water and also owns a 56.9% stake in a publicly-traded homebuilder called UCP. Inc. (NYSE:UCP). I am attracted to PICO given what I consider to be both a substantial margin of safety and the potential for significant upside to the current share price.

PICO has a market capitalization of $225 million and has a clean balance sheet with no debt and almost $10 million in cash. All debt shown on the balance sheet (and all financial websites) is held at UCP and only shows up on PICO's balance sheet due to accounting rules on consolidation. I prefer to treat UCP as a marketable security and PICO's stake in UCP is currently worth over $80 million. That means the market is valuing the remaining assets of PICO (including Vidler Water) at approximately $140 million. The book value of the water assets is over $184 million and I believe book value significantly understates the true market value. Vidler owns water assets in growing and drought-ridden cities such as Reno, Phoenix, Las Vegas, and Santa Fe that could be worth well over $400 million.

There are lingering concerns on PICO's corporate governance policies that often are often raised by the investment community. Long-time CEO John Hart has been handsomely compensated even though the company has not been profitable for some time and has undertaken a number of investments that have resulted in the destruction of significant shareholder value. In late 2015, the company revised its strategy and stated its new intention to monetize PICO's asset base and return capital to shareholders. Importantly, this strategic change greatly reduced the risk that additional value-destroying investments are pursued. Corporate governance has also markedly improved, with 5 new shareholder-friendly board members joining the board of directors since December 2015. In my view, this combination of factors results in a company with limited downside, sizeable upside, and a renewed board level focus on returning value to shareholders.

Thoughts on the economy?

That is a question that I could spend a lot of time on, but I will attempt to keep it relatively simple. The U.S. economy has undergone a major improvement following the Great Recession and is now experiencing slow growth and very low level of unemployment. The problem is that these gains were only achieved through a combination of unconventional monetary policy and rising government debt balances. I am very concerned about the elevated level of government debt outstanding at all major developed economies. This debt burden will likely be a major impediment to growth going forward and greatly increases the risks to the financial system. In addition, the central bankers of the world have taken it upon themselves to utilize unconventional measures in order to stimulate the economy. This has resulted in a search for yield by the investment community which has led to elevated prices across a number of asset classes. Ultimately, someone will have to pay for the monetary stimulus that has been delivered and asset prices will return to more normal levels - the timing and severity of the future correction remains in question.

Advice for someone who wants to become a full-time investor?

My advice here varies depending on each individual's situation. For people that are early in their careers, there are a number of steps I would take. I encourage everyone to start managing at least a small portfolio of their own in order to learn from both successes and failures. No investment style is correct for everyone, and it is important to understand your own strengths and preferred investment approach. I also tell young professionals to work hard to develop accounting skills - these are the language of business and are necessary for reading and understanding financial statements. Finally, I would attempt to meet and network with other investors in your local community. This can further help develop your self-awareness on the type of investor you want to be and can be an important networking tool in landing a full-time opportunity.

For experienced investment professionals, the ultimate goal is often to launch an investment fund. For those professionals, the best advice I can give on timing is to have the utmost confidence in your investment approach (whatever it may be) before going out on your own. The responsibility of being a fiduciary is extremely high and there will be times when investment performance is not what you hope it to be. By having complete conviction in your own investment strategy you offer potential investors with a product that you truly believe has real long-term value. In addition, having this conviction allows you to stick to your strategy even when things are not going well, limiting the likelihood that a fund manager ventures into asset classes or strategies where they have little experience.

Where can readers reach you?

Readers can visit www.gatecitycap.com for additional information or can contact me via email at info@gatecitycap.com. Of note, the Fund is limited to accredited investors. That being the case, I enjoy learning about new investment ideas and am also open to speaking with young investors as they consider a career in investments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.